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Sunday, July 18, 2010

Chart of the Day: Earnings Yield

Earnings, earnings, earnings! Ultimately nothing matters more then earnings. You work for a paycheck or earnings. You invest for the earnings of the company. Unfortunately the stock market has become much more of a game of playing the technicals or riding the latest momentum trend when ultimately it should be about the future earnings potential of a company. That's the basic theme behind the philosophy of Warren Buffett.

Lots of other investors chase dividend yields or the safety of treasuries. Amazingly very little is talked about the earnings yield of stocks or investments. Good SP500 stocks can yield 3 or 4% and is some cases even 6 or 7% dividends. What does that really mean? Can they really afford to pay that dividend or can they afford to pay a ton more. Heck even our Net Payout Yield Portfolio that has beaten the market on average of 5%+ over the last 3+ years only focuses on buyback + dividends and nothing on the earnings yield. Sure its a sign of the cash flow coming plus the confidence of management down the road, but it never measures what the company should really pay out.

That's where the Earninsg Yield comes into place. In a way, its a version of the PE ratio, but when you place a yield on it you can compare investment classes such as bonds. Too much emphasis is placed on the PE ratio from decade to decade and a 15 is the historical average. So the current forward PE is getting closer to 11 which makes this market historically cheap. What about comparisons to other yields? After all, isn't a investment a choice between alternatives. Stock, bond, commodity, real estate, and money market/CD? In reality its usually just stock, bond, or money market for most people. So what about the bond rates? Well considering the 2 year government bond just hit a record low of around 0.5% I'd say that the PE ratio should hit a record high. Hence pushing the earnings yield down to match. Typically though investors compare the 10 year Treasury rate to the earnings yield and normally they trade in a tight range. That's why PE ratios were so low in the '70s. Why buy a stock if the Treasury yield was double digits?

The following chart shows how completely out of whack the markets have become regarding earnings. Intel (INTC) can report an all time record profits and the market basically shrugs it off. Amazingly though the only other option is historically low interest rates. I'd say more then a few financial advisors are going to be trying to explain to clients why they stuck their money in bonds at the lowest rates on record. The SP500 yields 8.75% while the 10 year comes in at 2.96%. Whats incredible is that so much fear exists that its even a question! When the market comes back to live it'll be another incredible ride.